Much of the focus of the tax community on the Supreme Court’s recently completed 2023-2024 term was on the case of Moore v. United States (Docket No. 22-800), which kept open the possibility of a wealth tax in the United States in the future. While the Moore decision is important, there was another tax case decided during the Supreme Court’s recently completed 2023-2024 term that also deserves attention – Connelly v. United States (Docket No. 23-146).
The Connelly case involved Crown C Supply, a Missouri building supply corporation (“Crown”). Crown was owned by two brothers – Michael Connelly (77.18% shareholder) and Thomas Connelly (22.82% shareholder). Michael and Thomas entered into an agreement that if either died, (i) the surviving brother would have the option to purchase the deceased brother’s stock, and (ii) if the surviving brother declined to exercise this option, Crown would be contractually required to purchase the deceased brother’s stock. Crown obtained $3.5 million in life insurance on each brother to have the available funds to purchase a deceased brother’s stock, if necessary.
Michael died in 2013. When Thomas decided not to purchase Michael’s stock, Crown was contractually obligated to purchase Michael’s stock. It was agreed that the value of Michael’s stock was $3 million, and Crown used $3 million of the life insurance proceeds it received on Michael’s death to purchase Michael’s stock. This valuation of $3 million was based on 77.18% (Michael’s percentage ownership interest) of a determination that the fair market value of Crown at Michael’s death was $3.86 million. In making this determination, the life insurance proceeds received by Crown were deducted from the fair market value of Crown because they were “offset by an obligation to pay those proceeds to the estate in a stock buyout”.
The $3 million valuation was included on the Federal estate return for Michael’s estate. The Internal Revenue Service audited the return and took a different view. It valued Michael’s stock at the higher amount of $5.3 million – 77.18% of a determination that the fair market value of Crown at Michael’s death was $6.86 million. The Internal Revenue Service fully included in this determination the life insurance proceeds received by Crown because “Crown’s redemption obligation did not offset the life insurance proceeds”. Based on the higher valuation, the Internal Revenue Service found that Michael’s estate owed an additional tax liability of $889,914.
The case came to the Supreme Court “to address whether life-insurance proceeds that will be used to redeem a decedent’s shares must be included when calculating the value of those shares for purposes of the federal estate tax”. In a unanimous 9-0 opinion, written by Justice Clarence Thomas, the Supreme Court stated:
“The dispute in this case is narrow. All agree that, when calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. And, all agree that life-insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. The only question is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption. . . . We agree with the Government.
An obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest. A simple example proves the point. Consider a corporation with one asset – $10 million in cash – and two shareholders, A and B, who own 80 and 20 shares respectively. Each individual share is worth $100,000 ($10 million ÷ 100 shares). So, A’s shares are worth $8 million (80 shares x $100,000) and B’s shares are worth $2 million (20 shares x $100,000). To redeem B’s shares at fair market value, the corporation would thus have to pay B $2 million. After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares. A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares). Economically, the redemption would have no impact on either shareholder. The value of the shareholders’ interests after the redemption – A’s 80 shares and B’s $2 million in cash – would be equal to the value of their respective interests in the corporation before the redemption. Thus, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.
Because a fair-market-value redemption has no effect on any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares. At the time of Michael’s death, Crown was worth $6.86 million – $3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income-generating potential. Anyone purchasing Michael’s shares would acquire a 77.18% stake in a company worth $6.86 million, along with Crown’s obligation to redeem those shares at fair market value. A buyer would therefore pay up to $5.3 million for Michael’s shares ($6.86 million x 0.7718) – i.e., the value the buyer could expect to receive in exchange for Michael’s shares when Crown redeemed them at fair market value. We thus conclude that Crown’s promise to redeem Michael’s shares at fair market value did not reduce the value of those shares.”
Businesses commonly survive and continue beyond the lives of their owners. As a result, it is prudent (as was done by Michael and Thomas Connelly with respect to Crown) for business owners to enter into agreements that address “post-death” issues concerning the business. When these agreements concern the purchase of ownership interests in the business, they are referred to as “buy-sell” agreements. “Buy sell” agreements often are funded by life insurance policies. “Buy-sell” agreements also can cover other conditions besides death, such as disability, retirement, termination of employment, bankruptcy, and divorce.
Nothing in the Connelly decision questions the wisdom of business owners continuing to execute “buy sell” agreements. However, the general conclusion of the Connelly case – life insurance proceeds, but not an obligation to use these life insurance proceeds to redeem a deceased business owner’s ownership interest, can affect the “estate tax” valuation of such deceased business owner’s ownership interest – can have material implications for the terms of “buy-sell” agreements, business valuations, and other estate tax liability and estate planning issues.
If you have any questions concerning the Connelly case or “buy-sell” agreements, please discuss them with your advisers.
Note – “FinCEN” Reporting
On September 10, 2024, the United States Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) issued four FAQs concerning how certain companies subject to “FinCEN” reporting under the Corporate Transparency Act (“reporting companies”) that are dissolved or cease to do business in the United States prior to the date they are required to file their “Beneficial Ownership Information Report” (“BOIR”) still may be subject to “FinCEN” reporting. It is important to remember that reporting companies that were formed or registered to do business in the United States on or before December 31, 2023 are required to comply with applicable “FinCEN” reporting by January 1, 2025 and reporting companies that were formed or registered to do business in the United States during 2024 are required to comply with applicable “FinCEN” reporting within 90 calendar days after receiving notice of such formation or registration. Through the end of August, 2024, it has been estimated that over 3.8 million reporting companies have filed BOIRs. Reporting companies are subject to significant civil penalties and even criminal penalties for failure to comply with applicable “FinCEN” reporting.
If you have any questions concerning “FinCEN” reporting, please discuss them with your advisers.
If you wish to discuss any of the above, find Pen Pal Gary’s contact info here.
Disclaimer: please note that nothing in this article is intended to be, or should be relied on as, legal advice of any kind. Neither LHBR Consulting, LLC nor Gary Stern provides legal services of any kind.
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